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The US economy is limping through the second half of the year as the impact of this summer’s stimulus checks fades. The continued weakness, I suspect, will come as a shock to the public, who have now been essentially promised that their problems will be solved with a bailout package they really don’t understand to begin with for the financial sector they view as arrogant aggregators of wealth.

But any bailout will only prevent a financial meltdown that threatens to deepen the credit crunch and worsen the ongoing slowdown, not reverse the current weakness. I doubt, however, the general public sees that distinction. And they are not likely to be convinced; this Administration sacrificed its credibility long ago.

Instead, the public will see billions channeled into Wall Street as the unemployment rate climbs. And climb it will.

The flow of data this week, for those paying attention, is decidedly negative in tone. The housing market continues to deteriorate, with a precipitous decline in new home sales reported today. By definition, we must be closer to a bottom on new construction – but, to say the least, that bottom remains elusive. Initial unemployment claims, reached nearly 500,000 last week, although the Department of Labor attributes roughly 50k to the impact of recent hurricanes.

Still, initial claims hovering around 450k foreshadows another weak employment report next week. Perhaps the most discouraging report this week was the advance durable goods release, which revealed a 2% decline in new orders for nondefense, nonaircraft capital goods. As Spencer at Angry Bear notes, the report is a negative for third quarter GDP.

In my opinion, the stimulus package revealed the staggering dependence of US households on debt supported spending. Cash funneled to households via the mortgage markets fueled the recovery from the 2001 recession, but at the cost of driving housing prices to unsustainable levels.

This financing channel broke down when it became evident that household income was fundamentally incapable of supporting the debt loads necessary to sustain elevated housing prices. Credit markets contracted as underwriting conditions returned to traditional standards.

I see this as a permanent shift to a more sustainable equilibrium; credit needs to be extended on the basis of ability to pay, which ultimately reflects household cash flow (income). Housing prices need to adjust accordingly. Hoping for a rebound in housing prices to reverse current trends is, in my opinion, naïve.

To compensate for reduced access to capital markets, policymakers initiated a fiscal stimulus package to put cash in the hands of households. The debt necessary to support the package was floated onto financial markets and absorbed by foreign central banks.

Households traded one debt-financed cash infusion for another. Because, as should have been expected, housing markets did not recover over the summer, the government stimulus provided only temporary relief.

Households need a steady source of cash beyond their incomes to support their consumptive proclivities; without some artificial support, consumer spending will contract as a percentage of overall economic activity. I tend to believe this process is inexorable. Economic growth needs to become less dependent on consumer spending to be sustainable in the long run. Policymakers can cushion the blow, but policy should avoid entirely resisting the adjustment.

The fall in housing prices, and outright mortgage defaults, crumbled the base of Wall Street’s financial pyramid. A collapse of that pyramid threatens to spread and deepen the credit contraction beyond that already seen in housing.

To be sure, a certain amount of additional contraction is almost certain as financial firms deleverage to more sustainable balance sheets. But this process threatens to turn disorderly quickly, which would generate a more significant credit crunch than is either necessary or desirable.

The implications for Main Street are severe. Consequently, some sort of bailout for the financial sector is justified, in my opinion. I think the collapse of credit markets is something to be avoided if possible. I remember emerging Asia. We are not that different.

Congressional leaders were pulling together the final details of a bailout package to stem the bloodletting on Wall Street. The details may have been less than desirable. Indeed, it remains an extremely difficult sell to the public, especially when those who benefit are impolitic enough to suggest the following:

There also is the human cost to the financial floods, the collective psychological breakdown that occurs when Greenwich’s billionaires become mere millionaires. “It’s the human toll that is frightening,” said State Rep. Livvy Floren, a friend of Mr. Fuld. “Dick Fuld has spent 39 years of his life doing this. It’s more than just money. They’re not going to be in the streets starving….I think the man worked 24/7. His family and Lehman (LEH) are his life.”

A deeper analysis was offered by local Democrat Ned Lamont, who in one fell swoop compared Greenwich’s money woes to the Japan malaise, Asian tsunami and the New Orleans flood. “It really is a financial tsunami, and it could go either way,” said the multimillionaire telecommunications mogul who ran for the U.S. Senate in 2006. “It took Japan 20 years to recover from their buying binge. How long does it take us to work through excessive leverage? That could take years not months. This is our Katrina.”

I have yet to meet a soul on the street who accepts that it is necessary to move forward on a fix to the nation’s financial underpinnings. With comments like these, is it any wonder?

Tonight we learned, however, that Republicans sabotaged a pivotal meeting today at the White House; the details are very distressing – see MarketWatch, Paul Krugman and Brad DeLong.

The Republicans are playing with fire; the lack of leadership on this issue is mind numbing. While I disagreed with certain elements of the initial proposal – nonexistent oversight is not a privilege this administration has earned – I believe there is a clear need for a comprehensive solution. And it is naïve to believe that the solution will come without a cost to taxpayers. No bailout is ever a free lunch. It is equally naïve, however, to believe that failure to act will be costless.

My hope is that a bailout is coming. But it will not change the path the economy is already on, it will only prevent activity from shifting to a new, less desirable path.

I don’t quite see how the billions of dollars plowed into this program will be funneled to households. I see instead it will only cushion the process of deleveraging, and thus minimize the quantity of resources stripped from the economy.

This is important and necessary, but will not provide a miracle cure for the economy’s travails.

Assuming a bailout comes to fruition, my attention will turn to the following:

1. What is the course of monetary policy? Increasingly, expectations are building for additional rate cuts, as much as 50bp as early as Monday. Federal Reserve Chairman Ben Bernanke’s shift to a more dovish tone from Tuesday to Wednesday appears to open the door to additional rate cuts.

I think, however, that was not Bernanke’s intention. Instead, he felt it necessary to more forcefully press his case to Congress. That said, economic activity is decelerating, which, combined with the recent credit tightening, would typically prompt a rate cut – if the Fed had not already cut interest rates well ahead of their usual timing.

And I suspect that Bernanke & Co. are more disposed to turn their attention to fixing the financial system, seeing that, rather than additional rate cuts, as the key to reinvigorating (or at least stabilizing) economic growth. Overall, I doubt they are interested in an intermeeting cut, and would prefer to wait until the December meeting.

If you are a cynic, however, and you believe there was a quid pro quo between Bernanke and Congressional leaders, then the Fed will cut rates next week. If so, the Fed would be openly abandoning its independence. Maybe it has come to that point. Nothing surprises me anymore when it comes to rate policy.

2. Will Congress step up to support Main Street? After the billions for billionaires' bailout, it will be almost impossible to justifiy not taking further action to support Main Street, especially as labor markets deteriorate. It is not “if,” but “when,” with only the nature and size of stimulus to be decided.

3. How will the bailout and fiscal stimulus be financed? If it is not deficit spending, it will not be stimulative.

My preference is for policy to focus on restructuring, not stimulus. Accept that we cannot deficit spend our way to prosperity, and support the bailout and additional stimulus via a tax increase on top income earners, those who have benefited most from Wall Street’s orgy of debt.

I recognize, however, that it would be silly of me to actually expect that Americans would stand for self-financing their problems, and instead foreign central banks will be called upon to finance the bailout and future stimulus.

4. What will be the consequences of flooding global financial markets with more US Treasury debt? We will get another lesson in the world’s tolerance for absorbing low-yielding US assets. As long as foreign central banks continue to buy US debt no questions asked, the lesson of the Reagan years hold true – deficits don’t matter (unless of course, we set off another burst of global liquidity that fuels commodity prices).

If global financiers balk at acquiring the debt, then deficit will matter, and domestic interest rates would rise quickly. Place your bets, but realize that betting against the Bank of China has been a loser's bet.

With the bailout package currently in doubt, however, my worry is that credit markets will collapse Friday morning. Under these circumstances, the Fed would likely be forced into cutting interest rates in an intervening move. With Congress nipping at their heels over their handling of the crisis to date, and Republicans undermining the bailout package, monetary policymakers may simply be out of other tricks.

Good luck Friday…these are treacherous times.

Source: Regardless of a Bailout, US Economy is Decelerating